Under Generally Accepted Accounting Principles, or GAAP, manufacturing overhead must be allocated to each item produced. Manufacturing overhead is the expenses associated with the manufacture of products that can’t be immediately assigned to a particular item, such as the cost of raw materials. Items in this category can include electricity to light the plant and power the machines, rent for the factory and depreciation for the equipment. Allocating these costs can help managers determine the profitability of each product manufactured so they can make decisions on pricing, expansion or discontinuation of a product line.

Activity Based Costing Allocates Manufacturing Overhead based on Activities

1 List all the categories of manufacturing overhead. Sum up the expenses involved in each category through the time period. For example, if a manufacturer produces two items and one item takes 10 hours of labor while the other item takes 90 hours of labor, then 10 percent of manufacturing overhead could be allocated to the first item and 90 percent to the second item. Activity-based costing takes this approach to the next step by allocating overhead based on multiple activities. This generally allows for more accurate identification of the actual costs involved in the manufacturing process to each item produced. time period.

2 List the relevant activities involved in the manufacturing process. For example, labor, machine hours, and testing.

3 Allocate the expenses identified by manufacturing overhead category into each activity in the manufacturing process.

4 Determine the share of each activity the production demands for each product manufactured. For example, batch manufacturing machines need to be setup for each production batch. If Product A requires eight setups per period while Product B requires only 2, then assign 80 percent of the setup costs to Product A and 20 percent to Product B.

5 Divide the total costs per product line by the number of items produced. This is the allocation of manufacturing overhead per product.